DeFi
September 28, 2022
What is Token Burn and it's effects on price
An A-Z guide on token burning and how it is largely impacting the cryptocurrency industry.
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The true purpose of cryptocurrencies is to create a decentralized version of the capitalized world we currently live in. However, no one ever gets to experience complete decentralization in the presence of centralized bodies like CEX.
To make the finance sector fully decentralized, the DeFi ecosystem was created and liquidity pools are the backbone of these DeFi protocols. Liquidity pools allow traders to buy or sell their crypto without the need of using centralized exchanges as a medium.
In this article, we are going to understand the working of liquidity pools, their importance in the DeFi ecosystem and where can you make use of these liquidity pools. Let’s begin with understanding the concept of liquidity pool.
A liquidity pool is basically a collection of money or funds that are locked with smart contracts. Liquidity pools are utilized to help with the decentralized trading along with lending money but they are not the only things these pools are used for, they are used for a number of other things as well that you will find out about further in this article.
DEX or decentralized exchanges make use of liquidity pools to execute their transactions. Liquidity providers add two tokens that are of equal value to the pool and that creates a market in exchange of which, they get the trading fees from the traders that come to trade in these liquidity pools.
The fees that these liquidity providers get is based on the amount of tokens that they add in the pool. Liquidity providers make use of these pools as a passive way of income in the crypto world.
The liquidity pools can be accessed by any trader or liquidity provider and that is why Automated Market Makers or AMMs have made accessing the market as a whole a lot easier.
Uniswap, SushiSwap, Curve, Balancer, etc are some of the liquidity pools on the Ethereum blockchain. These pools have the ERC-20 tokens. On the Binance Smart Chain, you will find pools like PancakeSwap, BurgerSwap, etc, where they will have the BEP-20 tokens.
Decentralized exchange is one integral part of the DeFi protocol. DeFi is practical and even decentralized exchanges (DEX) make a lot of sense. But if you have used any of the DEX in the past, then the not so user friendly interface and lack of sellers and buyers should not be new to you.
Thus, even after being practical, DeFi protocols, primarily DEX, were not usable. The Automated Market Maker (AMM), however, changed the game by bringing the concept of liquidity pools in the DeFi to make DEX independent of any centralized exchange.
The AMM creates a liquidity pool to allow traders to liquidate their assets quickly and efficiently. On the other hand, AMM also incentivises liquidity providers by distributing trading fees among them.
Therefore, a liquidity pool is a medium through which traders can seamlessly buy and sell their assets without any third party involvement. Now let us try to understand the working of liquidity pools.
So far we know that a liquidity pool helps traders to quickly and easily liquidate their funds on decentralized exchanges. But the working of liquidity pools is an interesting process that you would love to understand.
Decentralized exchanges offer a liquidity pool. Anyone can contribute to the pool by investing tokens in a pair with a 50:50 ratio and they are known as liquidity providers. These providers get LP (liquidity provider) tokens equal to the amount of tokens that they have invested.
Later on as traders source liquidity from the pool, they are supposed to pay a trading fee which is then distributed amongst the liquidity providers along with rewards offered to them. Therefore, incentivising more and more people to contribute to the pool.
If traders are buying more of a particular token of the two tokens present in the pool, the value of the token will increase while depreciating the value of other tokens to maintain the overall balance of the pool. All these calculations are done by the AMM algorithm.
You already know that liquidity pools are used for AMMs but that is not the only thing that they are used for and the reason behind it is that these pools are a very simple idea and they function in a pretty straightforward way, this enables one to utilize them in a lot of areas. Let us see some of these popular uses.
Yield Farming is one of the most popular applications of DeFi, letting the users stake or lend their crypto assets, thus making good revenue from it. It is considered a good source of passive income. The application boomed and increased its market cap from $500 million to $10 Billion.
The LP (liquidity providers) generate revenue by staking or locking their investments in smart contracts. The smart contracts are based on a liquidity pool. Users earn a good return but it has certain drawbacks as well.
Minting synthetic assets means nothing but generating synthetic assets or tokens. These synthetic assets rely on the liquidity pools. When it comes to generating synthetic assets or one would say minting synthetic assets, liquidity pools are used.
In order to generate a synthetic asset or a token, all that needs to be done is adding some collateral to the liquidity pool and then connecting it to an oracle that is trustworthy. By doing so, you will have minted a synthetic asset that is secured.
Tranching is said to be a cutting-edge application of liquidity pools. It means nothing but classifying or categorizing financial assets primarily depending on the returns and risks. By doing so, the liquidity pools are enabled to select their own risks and returns.
The DeFi market is also spread in smart contract risk insurance. Liquidity pools have applications in this area; they provide certain safeguards here as well. You will find a lot of DeFi ecosystems making use of Liquidity pools to insure safety when smart contracts come into the picture as they are used almost everywhere concerning crypto these days.
Liquidity pools are truly an amazing thing in the present crypto world. They are one of the most essential parts of the DeFi tech that people use these days. When the liquidity pools come with so many advantages, you will be smart to make use of them as well.
If you want to know more about Liquidity pools, you should understand the topic of DeFi completely, so do check out our articles related to that as well. Liquidity pools can make you a lot of money. They aren't one of the best passive incomes of cryptocurrency for no reason.
You only need to choose the best platform suited to your needs and start earning. Do keep in mind that you shouldn't just invest your money anywhere, do your research properly, our articles related to Cryptocurrency would help you with that.
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